For a whole variety of reasons, all of them bad, I didn’t put so much as a dollar into a retirement account until I was 36 years old.

When I did start saving, I followed these four standard pieces of personal finance advice:

For long-term growth, put most of your money into stocks, balanced by a small percentage of bonds

Keep costs down with ETFs when available, and the lowest-cost mutual funds when ETFs are not an option

Diversify by owning broad swaths of the stock market, such as a total stock market fund or a S&P 500 index fund

Buy and hold rather than trying to time the market; rebalance to percentage allocations

Now, in the aftermath of the second-worst stock market crash in American history, I still subscribe to the last three principles. However, I’ve completely rejected the first one. I no longer keep a majority of my investments in the stock market.

In fact, I no longer keep even half of our joint retirement savings in stocks.

• • •

Sacrilege, right?

Almost everyone loves stocks for long-term investing. Robert Brokamp, writer at the Motley Fool and Get Rich Slowly, goes so far as to say, “There’s really only one place your retirement savings should go”:

The inexorable pressure on the stock market is upward. The biggest bang for our buck will be found in stocks. … Stocks beat bonds for 90% of the rolling 10-year periods, and essentially 100% of the rolling 30-year periods.

He admits, but downplays, the fact that “from 2000 to 2002 many people lost more than half their life savings in the market”.

Well, in 2000 times were tough all right, but I didn’t have any investments. I had credit card debt instead. So 2008 was really the point at which I discovered that I was not okay with losing half — or even a third or a fifth — of my hard-won savings.

The truly difficult part, however, was finding an alternative. Bonds, as pretty much everyone points out, do worse on average than stocks. Cash is a losing proposition at this point, as even top-rate 5-year CDs can’t keep up with inflation.

What’s a risk-averse girl to do?

• • •

Eventually, I ran across an option that made sense to me. It’s called the ‘Permanent Portfolio’ and mercifully, it also happens to be simple.

Take one-fourth of your savings and put it into each of the following:

total stock market

long-term Treasury bonds

gold bullion

cash

The basic idea is that no matter what’s going on with the economy — prosperity, recession, inflation, deflation — some portion of your money is going to be doing well enough to offset the losses in the other part.

In fact, out of the last forty years, the PP has lost money only twice, with the largest loss being less than 4%. (The PP has only been a viable strategy since 1972, after the US went off the gold standard.) By contrast, the stock market has had ten out of forty losing years, including six years of losses in the double digits.

The compound annual growth rate of the PP hovers around 9.7% year-over-year. That’s very close to the historical average return of the stock market. (For a detailed breakdown, see Craig Rowland’s post on the PP’s historical returns.)

I’ll come back to the mechanics of the PP another time, but for now let me point you to JD Roth’s excellent write-up from April of 2009. He liked the Permanent Portfolio for most of the same reasons I do.

“Today, many analysts agree that Browne’s permanent portfolio relied too heavily on metals and T-bills and underestimated the growth potential of equities and bonds.”

To which I say: if so, ‘many analysts’ are missing the point.

The point is not to outperform the stock market every year. In fact, if the stock market is doing spectacularly well, the PP is guaranteed to significantly underperform it.

But here’s the flip side: when the total stock market is doing spectacularly poorly, the PP will chug right along, hardly missing a beat. Next to the PP, any variation of the standard stock-bond dichotomy looks about as stable as a two-legged cow.

At the end of 2008, when our household suddenly lost 80% of our income, our already-insufficient pool of retirement savings was also hemorrhaging tens of thousands of dollars. If we’d been allocated into the PP at that time, our retirement fund would have remained steady, even seen incremental growth of 1% or so.

That kind of stability and controlled growth is worth a lot to me. It’s worth missing a chunk of the upside of a bull market sprint.

Is it worth it to you? Let’s find out.

• • •

Scenario A

You have $100,000 invested. Your gains for the year were modest $7,500. But everyone else you know is flying high with a 31% return. You thought you were being smart to play it safe, but now you’re kicking yourself for having missed out on a $23,500 gain.

Scenario B

You have $100,000 invested — or you did, before the nosedive which cost you $36,700 in a single year. You have a lot of company, as almost everyone else suffered huge losses too. But not your best friend, whose portfolio had a tiny uptick of 1.9% for the same period. If you’d only listened to him last year you wouldn’t have lost a thing.

• • •

Which of those two situations is more stomach-clenching for you?

Scenario A is the downside to the Permanent Portfolio — that’s what actually happened to PP investors in 1997, as compared to the Total Stock Market.

For me personally, Scenario B is worse. That’s what a Total Stock Market investor experienced in 2008.

If you’d happily take A to avoid B, you should consider moving into the Permanent Portfolio.

My educated suspicion is that most people would choose A over B, because of the psychological phenomenon known to behavioral economists as loss aversion. In a nutshell, the prospect of losing something is much more painful than the prospect of failing to gain the exact same thing.

On the other hand, sticking with the PP means actively avoiding herd behavior, which is not an easy task for most humans. We’re wired to feel better when we do the same things other people are doing.

And most investors are not limiting their stock market exposure to 25%.

• • •

Here’s the other factor: I no longer believe in the inevitability of stock market growth, at least not over periods corresponding to a single human lifetime.

That one’s life savings should be invested primarily in stocks, with a small percentage of bonds for ballast, is one of those bits of common financial wisdom, like ‘mortgage debt is good debt’, which at first I just accepted as given.

Even in the midst of contradicting evidence, I didn’t question the precept. Events like the crash of 2000-2002 were always characterized as minor speed bumps on the highway to certain riches.

But I now believe that the idea of the ‘inexorable upward pressure’ of the stock market will eventually be considered as naive and foolish as the idea that ‘housing prices always rise’.

The details are for another time, but over the last three years I’ve studied enough of both history and global economics to have concluded that the growth period in the United States from 1975 to 2000 was both artificial and unsustainable, and that even the larger run-up going back to the end of World War II was a generally unrepeatable one-time historical event. In the words of Yale economist Robert Shiller, “This was the most economically successful century for the most economically successful nation of all time. It will not necessarily repeat itself.”

Worse, I have become convinced that much of the value supposedly created in the last quarter of the twentieth century was actually borrowed from the future, and that what we’ve seen over the last few years is, in a way, the very first of those debts coming due.

There will be more losses ahead. A lot more, probably spread out over decades.

Along the way, though, US stocks will still have some banner years. After a bumpy and ultimately lackadaisical 2011, the market has leapt out of the gate in early 2012. It’s entirely possible that this will be one of the years in which a simple total-market index fund leaves my portfolio in the dust.

I’m okay with that.

As PP enthusiast Craig Rowland has said, “Everyone thinks their horse is the one that’s going to win the race. I don’t want to win the race. I just want to finish without having my horse break a leg and need to be put down for good.”

13 responses

I ran across the permanent portfolio way back in the 1980s. I didn’t invest in it exactly, but it influenced how I did invest, and I paid some attention to its performance right along.

After the price of gold collapsed from the huge highs it hit back in 1980 or so, you could get an ounce for something in the low $300s.

Over the next 20 years, gold went nowhere. It spent plenty of time under the price you’d have bought it at, even if you caught the early 1980s low. And all that while earning no income, and while inflation (although much lower than it had been) was still eating away at its value.

It’s pretty tough to take a position and stick with it for decades, when it’s not doing any better than that. Especially since stock and bonds did so well.

Of course, the gold I bought at $300 is looking pretty good now. But I’m kind of doubtful about gold bought at $1700. Of course, I’ve been wrong before. That’s the win of the permanent portfolio—it doesn’t much matter if you’re wrong.

Yes, that’s exactly the win. I just assume that I’m going to be wrong more often than not, since that’s statistically true for the overwhelming majority of investors, including professionals. I’m not comfortable trusting my future to pure luck, so a plan where you can be wrong and still come out ahead sounds good to me.

As far as sticking with it, I guess that’s the same problem any investor has. Most people panic at sharp movements and react in exactly the wrong direction. I think the fundamentally stable nature of the PP will make it easier for me to stay with it than anything else I might pick.

It’s definitely hard to get started, due to fear that at least one quarter of your portfolio will immediately move in the wrong direction. I know the rational approach is just to buy all three legs at once, but I couldn’t always make myself do that. I had to play mind games, like buying during short-term dips. After that initial hump, though, I’ve found the whole thing very reassuring.

Great post! The PP provokes a ton of controversy, but as long as you stick with it and keep costs low, it seems well within the realm of reasonable.

Here’s my question for you, and it’s not meant as a criticism of the PP whatsoever: as you said, it’s a defensive portfolio. I’m a conservative investor, and I get that. What concerns me about the PP is that people tend to overestimate its expected return based on past performance. Here’s the expected real return of 3/4 of your portfolio:

Again, there’s nothing wrong with that; a substantial portion of my portfolio is in TIPS, with negative real return. However, it implies a hefty savings rate. On the other side, of course, are all the good arguments you made against an equity-heavy portfolio: sure, it MIGHT deliver better performance, or it might turn out much worse than the PP.

This is the dilemma middle-class investors face: because real rates are so low, you’re stuck choosing between a high risk portfolio and hoping for the best, or a low-risk portfolio and an agonizingly high savings rate. My question to you, then, is: do you save at the high rate that your defensive portfolio requires? And if so, what rate did you come up with?

That’s the average real yield to maturity on outstanding 10+-year TIPS. If you invest in something super-long like EDV or individual 30-year securities, you can pick up a little more yield; the yield on the 30-year TIPS is 0.7 or so. Yes, that is stupefyingly low. If bond rates increase (please!) during your accumulation years, you’ll have ample opportunity to buy higher-yielding bonds, but 0.35% is probably a very good estimate of what is going to happen to the dollars you invest today. (But who knows? Weird things happen.)

Okay, that explains it. The ‘long bonds’ portion of the PP is intended to be as close to 30-year as you can get, and no less than 20. So yes: EDV, 30-year individual bonds, also TLT is very popular. I calculate a 4.27% return off TLT for calendar year 2011 — just in monthly dividends, not counting the very considerable price appreciation, which clocked in at 29.54%. (Craig separately calculated 33.56% for TLT in 2011, which is close to my 33.81% total.)

Also, TIPS are not appropriate for the long bonds section. I personally fall into the majority ‘avoid TIPS’ camp, but if you really want to include TIPS, they are a better substitute for gold, as they are intended as an inflation hedge, and long bonds are there primarily for the opposite situation, deflation.

Okay, but you can’t spend nominal growth, only real growth, and you can’t buy last year’s yield, only this year’s. (Man, I sound like the world’s worst fortune cookie.) The bond market is saying it expects that if you buy a 30-year bond today, you’ll earn 0.7% annually in real returns, including capital appreciation and reinvested coupons. The bond market could and probably will be wrong–but we don’t know in which direction, and historically it’s been pretty accurate. In other words, that’s the best estimate out there.

Here’s what I’m saying. Once you get to a certain age, you can start to see the full contour of your human capital, and it’s no longer responsible to kick $50 a month into a Roth IRA and say, “Well, at least I’m saving something.” But in order to figure out how much to save, you have to make some estimate of the expected return of your portfolio. For my portfolio, I’ve estimated 1.8% (real). That is a far cry from the 8% (or whatever) thrown around by stock-drunk financial planners, and it means I have to save a lot. I started early, but it still comes to about 20% of my income. (Family income, really.)

Your portfolio, like mine, has a low expected real return. Honestly, it probably has lower volatility than my portfolio and higher expected return, but the fact that the PP has performed well in the past is relevant in terms of future volatility (the assets in it are very different and will probably stay highly uncorrelated, which is great) but irrelevant in terms of future performance. You have to use a forward-looking measure based on the asset allocation of the portfolio. If you’re assuming a rate of return higher than maybe 2.5% at the very most, I don’t see how that can work. You MIGHT get more than that, sure, but it would be a bad assumption.

So again, given the fact that you have a defensive portfolio with low expected returns and you admit you got a late start on retirement savings, what’s your savings rate? It has to be painfully high, right? I am a fan of conservative portfolios, obviously, but they go hand-in-hand with high savings rates. In the current environment, especially, a conservative portfolio plus a low savings rate is worse than the darts we throw at an equity-oriented portfolio, because instead of possible failure, you have nearly guaranteed failure.

A few points: One, stop equating 30-year T-bonds with 30-year TIPS. The rates are different, for good reason! Two, I didn’t cover the rebalancing aspect of the PP in this post (I had to stop somewhere, and I intend to come back to it), but it does effectively allow/force you to pull value out on the high side — converting significant nominal growth to real growth. Three, I never do automatic reinvestments, for similar reasons — the coupon payments go into cash, and are dealt with as part of the rebalance.

The savings rate question I answered, I think, in a crosspost — look below. I’m not assuming any particular rate of return and working backwards; it’s more like ‘save as much as humanly possible’ under whatever conditions we’re experiencing that month. Which might be 25% or it might be 65% … heck, some month it might even be negative. But overall my conservative estimate is 25-30% average across the next five years while we’re still parenting. If we get lucky in income, we’ll do better than that.

I’m not as worried about setting a target and working backwards because we have a two-pronged approach to our future, of which saving and investing is only one half. The other revolves around shifting our income stream. We’re not looking to retire as in ‘stop working’ so much as ‘stop working for other people’.

The other thing I really want to emphasize — one of the main things I’m trying to communicate with Pocketmint over the long term — is that high savings rates do not have to be painful! Smart application of the principles of behavioral economics can make it pain-free. It’s working for us.

So even having cleared up the long-bond misunderstanding, I’m a little uncertain what you mean by ‘real return’. Normally I would assume that means price appreciation plus dividends/interest, adjusted for inflation? In which case yeah, I assume roughly zero on cash, maybe even a touch negative in certain environments, but gold is a huge question mark, not an assumed zero. True, it is the only slice that doesn’t provide dividend or interest income, and that’s a major consideration. But the value can (and often does) swing wildly.

But leaving that aside, your question about savings rate is very valid. And the short answer is yes, we’ve come around to the position of massive savings. Which is why I keep talking about frugality so much. :)

It sounds like you assume I’ve taken a target retirement amount and date and worked backwards to calculate how much we should be saving right now, but our situation doesn’t really allow that. Our employment is wildly intermittent; we both work contract jobs that tend to last a year or less at a time, with occasional random freelancing on the side. We’ve both had significant periods of total unemployment. So our income swings wildly from month to month, and isn’t even that steady year to year.

We are also locked in to Seattle — with its still-exorbitant housing cost — for the next 5.5 years due to child custody. So while we can, and are, making a move to reduce our housing expense as much as possible (see my next blog post), there are still sharp constraints on the expense side.

That said, our baseline budget, starting from a single income (our wages are near-equal) mandates a minimum 26-30% savings rate, depending upon 401(k) eligibility and match. In reality, we’ve beaten that in the short term on the frugality front alone, so I consider that to be sustainable on average over the next five years.

Should we get a second simultaneous income, that will go primarily into savings, bumping our savings rate to well over 60% for the duration. Right now we’re also packing away over 60%, due to a short-term quirk in our expense situation. And while that circumstance is certainly not sustainable, it does help.

In 2017 we will be 47 and 52, with an empty nest. We’re planning for big changes then …

I know people who use the permanent portfolio and it works fine for their purposes. You seem willing to give up the prospect of higher returns in exchange for less volatility, which i think is key for this portfolio. I do, however, think that you should consider carefully what your reaction would be if gold crashed (which history suggests is highly likely). You should also consider that that portion may not recover to its current levels for many, many, years. If you will be ok with that because it is only a quarter of your portfolio then this approach is fine for you. If this would be difficult for you to handle (financially or emotionally), you may want to decrease the gold % or make it more diverse by including other commodities. Sometimes these types of portfolios also include real estate (reits) to further diversify.

Hi Liz. What makes the possibility of plummeting value in 25% of my portfolio acceptable to me is the near-certainty that some other part(s) will more than make up the difference — and that’s true whether the crash comes in gold or stocks or bonds. No situation has ever occurred or even been imagined where if one of those goes through the floor, at least one other isn’t shooting through the roof.

Could there be some other economic condition besides prosperity, recession, inflation, and deflation, that hasn’t happened yet and no one has thought of? Maybe. But if so, it’s not something that anyone is able to prepare for now anyway. So in that (extremely unlikely) case, we’re all equally screwed.

My personal hunch is that gold will not crash but in fact will do very well over the next 20-30 years, just because the world economic situation is so very unstable. Europe is totally screwed, the US is in worse shape than most people realize … even China is in a huge real estate bubble.

But the nice thing about the PP is that I could be completely wrong about that and still come out okay.

I didn’t go into it in this blog post, but I do have up to 5% of our assets (currently 3.8%) in a ‘Variable Portfolio’, outside the PP. This is where I buy REITs and individual stocks. It’s basically my ‘play money’, the amount I can gamble with and we’re prepared to completely lose if I’m wrong. But I would never substitute REITs for gold in the PP, because they don’t behave the same way. Likewise, I don’t consider other commodities (including mining stocks) to be a substitute for gold; gold is unique in its economic properties.